Drug company R&D: Nowhere near $1 billion.

The Make-Believe Billion

How drug companies exaggerate research costs to justify absurd profits.

Donald W. Light of the University of Medicine and Dentistry of New Jersey

For years the government has sought to make brand-name drugs cheaper and more widely available to the public. It has tried and failed to limit to a reasonable time period various patent and other "exclusivity" protections. Or it's tried and failed to negotiate volume discounts on the drugs that the feds purchase through Medicare. Every time, the pharmaceutical lobby has used its considerable wealth and political clout to block any government action that might trim Big Pharma's profits, which typically amount to between one-quarter and one-half of company revenues. And just about every time, Big Pharma has argued that huge profit margins are vitally necessary to the pharmaceutical industry because drug research and development costs are so high.

The statistic Big Pharma typically cites (see, for instance, this PhRMA video on how Mister Chemical Compound becomes Mister Brand-Name Drug) is that the cost of bringing a new drug to market is about $1 billion. Now a new study indicates the cost is more like, um, $55 million.

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Big Pharma has been making its R&D argument for half a century, but the specific source of the $1 billion claim is a 2003 study published in the Journal of Health Economics by economists Joseph DiMasi of Tufts, Ronald W. Hansen of the University of Rochester, and Henry Grabowski of Duke. I will henceforth refer to this team as the Tufts Center group, because they were working out of the (drug-company-funded) Tufts Center for the Study of Drug Development. The Tufts Center group "obtained from a survey of 10 pharmaceutical firms" the research and development costs of 68 randomly chosen new drugs and calculated an average cost of $802 million in 2000 dollars. That comes to $1 billion in 2011 dollars based on the general inflation rate since 2000 (28 percent). One billion dollars for every little orange prescription bottle in your medicine cabinet! And according to PhRMA, even that is way too low! As of 2006, its calculation of the drug-development average had already risen to $1.32 billion. That means costs specific to drug development increased by 64 percent between 2000 and 2006. Medical inflation typically outpaces general inflation, but PhRMA's calculation puts its rate of cost increase at more than twice the rate for medical inflation during that period (26 percent). If Pharma's alleged inflation rate hasn't slackened since 2006, then the drug-development average should be now approaching $2 billion. But let's not go there. We'll stick to Big Pharma's official last-stated estimate of $1.32 billion.

The new study, by sociologist Donald W. Light of the University of Medicine and Dentistry of New Jersey and economist Rebecca Warburton of the University of Victoria, and published in the journal BioSocieties, builds on some excellent previous research by journalist and health care blogger Merrill Goozner, author of The $800 Million Pill, and the consumer advocate Jamie Love. Light and Warburton begin by pointing out that drug companies submitted their R&D data to the Tufts Center group on a confidential basis and that these numbers are therefore unverifiable. Light and Warburton find it a little fishy that only 10 of the 24 invited firms chose to participate, given "the centrality of the issue and the prominence of the Center" within the industry. "The sample," they suggest, "could be skewed" toward companies or drugs "with higher R&D costs." Light and Warburton also observe that if the Tufts Center group made any effort of its own to verify the information it received from the drug companies, the group makes no mention of it in the study.

The first research phase involved in developing a new drug is basic (as opposed to applied) research. Very little of this type of research is funded by drug companies; 84 percent is funded by the government, and private universities provide additional, unspecified funding. The Tufts Center group assumed that drug companies spent, on average, $121 million on basic research to create a new drug, but Light and Warburton find that hard to square with their estimate that industry devotes only 1.2 percent of sales to all their basic research. Add in a few additional considerations and Big Pharma would have us believe basic research costs end up constituting more than one-third of the Tufts Center's $802 million estimate. That's way too much, Light and Warburton say.

Another problem Light and Warburton have with the Tufts Center group is that they didn't subtract from their R&D calculations pharmaceutical firms' tax breaks. Research and development costs, they point out, are not depreciated over time like other investments; rather, they're excluded entirely from taxable profits. This tax break lowers net costs by 39 percent. Add in other tax breaks and that cuts the Tufts Center group's R&D estimate in half.

Now take that figure and cut it in half again, Light and Warburton say, because half the Tufts Center group's estimate was the "cost of capital," i.e., revenue foregone by not taking the money spent on R&D and investing it in securities instead. But R&D is a cost of doing business, Light and Warburton point out; if you don't want to spend money on it, then you don't want to be a drug company. And who says that investing in securities always increases your capital? Sometimes the market goes down. Many of us learned that the hard way in 2008.

There are other problems. The Tufts Center group's per-subject calculation of how much clinical trials cost was six times that of a National Institutes of Health study. Its calculation of how much time it takes to conduct clinical trials and have them reviewed by the Food and Drug Administration—7.5 years—is twice as long as Light and Warburton's calculation, which is less than four years. The Tufts Center group's use of the average (mean) cost rather than the median cost, Light and Warburton argue, is also misleading, because R&D costs for different drug products vary widely, and a very few expensive drugs will skew the mean. That appears to have happened in this case, because the Tuft Center group's median was only 74 percent of the mean.

When Light and Warburton correct for all these flaws—well, all the ones that can be quantified—they end up with an average cost of bringing a drug to market that's $59 million and a median cost that's $43 million. In 2011 dollars, that's a $75 million average and a $55 million median.

So the drug companies' $1.32 billion estimate was off, according to Light and Warburton, by only $1.265 billion. * Let's call it a rounding error.

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